AF 2012 V52N4 1041

Auditors’ going-concern-modified opinions after 2001:measuring reporting accuracy

Peter Careya, Stuart Kortumb, Robyn Moroneyc

aSchool of Accounting, Economics and Finance, Deakin University, Melbourne, Vic., AustraliabDeloitte Touche Tohmatsu, Melbourne, Vic., Australia

cDepartment of Accounting and Finance, Monash University, Vic., Australia

Abstract

An important change in auditors’ reporting behaviour in the period after thehigh-profile corporate collapses in 2001 is that auditors were more likely to issuegoing-concern (GC)-modified audit opinions. Comparing company failure ratessubsequent to receiving a first-time going-concern (FTGC)-modified audit opin-ion in the pre- and post-2001 periods, we find a consistent type 1 error (misclassi-fication) rate (the rate of survival among companies issued an FTGC opinion).Results are indicative of auditors maintaining GC reporting accuracy when com-paring the 1995–1996 and 2004–2005 periods. This conclusion is supported afterconsidering the impact of mitigating circumstances surrounding companies thatreceived an FTGC-modified audit report and survived.

Key words: Going concern; Audit reports; Bankruptcy

JEL classification: M42

doi: 10.1111/j.1467-629X.2011.00436.x

1. Introduction

The auditing profession was subjected to increased levels of scrutiny from themedia, public and regulators following the corporate collapses in 2001. The pub-lic outcry following the collapse of HIH in March 2001 and the bankruptcy of

The authors would like to gratefully acknowledge the helpful comments of participants atthe International Symposium on Auditing Research, the Accounting and Finance Associ-ation of Australia and New Zealand Annual Conference, the ANCAAR Forum at theAustralian National University and workshop participants at Monash University.

Received 23 August 2010; accepted 2 June 2011 by Robert Faff (Editor).

� 2011 The AuthorsAccounting and Finance � 2011 AFAANZ

Accounting and Finance 52 (2012) 1041–1059

Enron 8 months later saw a regulatory response that prescribed more explicitlyauditors’ responsibilities and reporting requirements.1 In this environment, it islikely that auditors’ reporting habits and procedures changed. There is evidencethat auditors issued more going-concern (GC)-modified audit reports post-2001(in Australia (Xu et al., 2011; Carson et al., 2006),2 the United States (Willekensand Bauwhede, 2004; Geiger et al., 2005) and Belgium (Carcello et al., 2009)).This change in reporting behaviour is consistent with auditors responding toincreased scrutiny by issuing more GC-modified audit reports. However, it isunclear whether auditors have achieved sustained accuracy in their GC reportingbehaviour.There are two types of errors or misclassifications associated with the GC-

modified audit reports which research has linked to auditors’ GC reportingquality.3 A type 1 error occurs when the auditor issues a GC-modified reportto a company which survives, and a type 2 error occurs when the auditor doesnot issue a GC-modified report to a company which subsequently fails(Hopwood et al., 1994). Analysis of variation in these misclassifications overtime has provided insight into the quality of auditors’ going concern reportingdecisions.Studies from the United States (Geiger et al., 2005) and Belgium (Carcello

et al., 2009) find fewer type 2 errors were made immediately after 2001 thanbefore, consistent with improved GC reporting accuracy. These authors suggesttheir findings are indicative of increased auditor conservatism through the

1 Regulatory changes directed at improving auditor independence included the AustralianCorporations Law reform in 2004 (CLERP 9) which following the recommendations ofthe HIH Royal commission (2001–2003) and in the US the Sarbanes–Oxley Act 2002.

2 In Australia, the proportion of GC-modified audit reports (first time and continuing)increased from around from 8 per cent during the 1996–2000 period to 15 per cent in2003 (Carson et al., 2006) and then levelled out to around 11 per cent in 2005 (Xu et al.,2011). The increases in GC-modified opinions were predominantly unqualified opinionswith ‘emphasis of matter’.

3 Drawing on custom from statistics, researchers have traditionally used the term ‘error’when referring to type I and type II errors. These ‘errors’ are perhaps more accuratelydescribed as misclassifications because they are not necessarily errors in the true sense ofthe word (i.e., see the discussion on page 4 concerning the inherent limitation of usingtype 1 errors as a measure of GC reporting accuracy). While we acknowledge potentialmisunderstandings which may arise from choice of terminology, we continue to use thedescription ‘error’ because current research also continues to use this terminology (See forexample, Carcello et al. 2009; and Feldmann and Read, 2010).

1042 P. Carey et al./Accounting and Finance 52 (2012) 1041–1059


issuance of a greater number of GC-modified opinions.4 However, Feldmannand Read (2010) found that in the United States, the type 2 error rate returnedto pre-2001 levels by 2006–2007, and Fargher and Jiang (2008) similarly reportthat Australia auditors GC reporting behaviour had returned to ‘normal’ orpre-2001 levels in 2004 and 2005.While the aforementioned studies have focussed on type 2 errors, the purpose

of this study is to compare type 1 error rates pre- and post-2001, to measure GCreporting accuracy over time. The only study to have investigated whether therehas been a change in the type 1 error rate after 2001 is the study of Carcello et al.(2009) who find a decrease in the type 2 error rate and a ‘concomitant’ increasein the type 1 error rate in a sample of private Belgium companies during the per-iod immediately after the Enron collapse (2001/2002). The Carcello et al. findingis consistent with the trend to greater conservatism through the issuance of moreGC opinions post-2001, and a corresponding increase in the type 1 error raterepresents a technical reduction in GC reporting accuracy. However, by focus-sing on a time period immediately post-2001 when the audit market was in itsgreatest turmoil, generalising this finding to latter time periods is problematic.This study contributes to the literature by providing evidence from the Austra-

lian market as to whether auditors have maintained GC reporting accuracy after2001 using the type 1 error rate to proxy GC reporting quality. Specifically, thisstudy compares the type 1 error rate for companies receiving a FTGC-modifiedopinion in 1995/1996 and 2004/2005, two comparatively stable periods.5 Whilethe type 1 error rate increased among private firms in Belgium immediately post-Enron (i.e. 2001–2002) (Carcello et al., 2009), prior research has not investigatedwhether the higher type 1 error rate continued after 2002. Drawing on researchthat suggests auditors GC reporting behaviour had returned to pre-crisis levels

4 Analysing data from the present study, it is noteworthy that Australian companies thatwent bankrupt in the 2004/2005 period were significantly more likely to have been issueda GC-modified opinion prior to failure than bankrupt companies in the 1995/1996 period(p < 0.01), indicating a lower type 2 error rate post 2001. Further, our data also indicatea higher number of first-time going concern (FTGC)-modified opinions issued in the2004/2005 period compared with the 1995/1996 period. A test of proportions reveals thatFTGC opinions (56) as a percentage of the total number of companies listed on the ASXissued during the 1995/1996 period are lower than FTGC opinions (108) as a percentageof the total number of companies listed on the ASX issued during the period 2004/2005,though the difference is only marginally significant (p < 0.10).

5 There was no difference in the proportion of public companies in the population thatwent bankrupt in 2004/2005 compared to 1995/1996. In the present study, bankruptciesare defined as companies that entered external administration within 12 months of fiscalyear-end and details were drawn from a custom report ordered from the Australian Secu-rities and Investments Commission (ASIC). According to this report, in the two-year per-iod 1995/1996, 21 companies went bankrupt, and in the 2-year period, 2004/2005, 40companies went bankrupt. The population of listed public companies was 1158 in 1996and 1667 in 2005, so the proportion of companies that went bankrupt comparing theseperiods are similar (i.e. 0.018 and 0.024 per cent).

P. Carey et al./Accounting and Finance 52 (2012) 1041–1059 1043


after 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010), we accordinglypredict that there will be no change in the bankruptcy rate among companiesreceiving FTGC-modified opinions (type 1 error rate) between the 1995/1996and 2004/2005 consistent with auditors maintaining GC reporting accuracy.A further contribution of this study is to provide a richer analysis of surviving

companies (the type 1 error subsample) through the identification of mitigatingevents, which may explain why firms receiving a first-time GC opinion survive.This analysis is conducted in response to the inherent limitation of using type 1errors as a measure of GC reporting accuracy. Some companies survive becauseof an event, such as a large injection of cash, which the auditor could not foreseeor confirm when signing the audit report. A mitigating event is defined in thepresent study as a large (comprising 10 per cent or more of the base amount)injection of debt or equity capital in the year following the issuance of an FTGCaudit opinion. A large injection of cash is one explanation as to why a companymay survive after receiving a GC opinion which is not indicative of audit failure.The type 1 error subsample is divided into two groups: those that disclose a

mitigating event and those that do not. In view of the increase in the proportionof GC opinions issued post-2001 compared to pre-2001 (Carson et al., 2006; Xuet al., 2011), a finding that there is a stable proportion of surviving companiesthat did not disclose mitigating circumstances pre- and post-2001 would providesupport for the argument that auditors have maintained GC reporting accuracy.We find that the type 1 error rate was static comparing pre- and post-2001 in

spite of increased GC reporting after 2001, which suggests that GC reportingaccuracy has not deteriorated. The proportion of surviving companies disclosingmitigating circumstances also remained unchanged over the same period. Theseresults confirm the overall maintenance of accuracy in FTGC reporting decisionsin Australia when comparing the 1995/1996 and 2004/2005 periods. The nextsection of this paper contains the background and hypothesis development,followed by the methodology and results. The final section contains concludingremarks.

2. Background and hypothesis development

Financial statements are prepared under the assumption that the entity willcontinue as a going concern. Where there is significant uncertainty regarding theappropriateness of the going concern assumption, the auditor will issue a GC-modified audit opinion. A GC-modified opinion may be an emphasis of matterto an unqualified audit report, where the client adequately discloses the GC issuein the notes to the financial statements, or a qualification, where the issue is notdisclosed or the auditor believes the issue is so serious as to warrant a qualifica-tion. The two types of errors or misclassifications in the context of a GC-modi-fied audit opinion are depicted in Table 1. A type 1 error occurs when theauditor issues a GC-modified opinion to a company which survives. A type 2error occurs when the auditor does not issue a GC modification to a company



which subsequently fails. As noted earlier, these ‘errors’ are perhaps more accu-rately described as misclassifications in the current context as they are not neces-sarily errors in the true sense of the word. For example, some companies survivefollowing a GC-modified opinion (type 1 error) because of a mitigating event,such as a large injection of cash, which the auditor could not foresee or confirmwhen signing the audit report. Similarly, while the failure to issue a GC-modifiedopinion to a company that subsequently fails is indicative of audit failure (type 2error), there will be situations where the auditor had not failed i.e. a client goingbankrupt after receiving an unmodified audit report in circumstances that werenot apparent at the time the audit report was signed.With each type of going concern misclassification, there are potential costs to

auditors, clients and financial statement users. When a company survives afterreceiving a GC-modified opinion (type 1 error), potential costs to the auditorinclude loss of reputation and loss of the client (Kida, 1980; Chow and Rice,1982; Carcello and Neal, 2003), and potential costs to clients include unwar-ranted financial hardship (Loudder et al., 1992; Blay and Geiger, 2001) and anincrease in the probability of company failure (Kida, 1980; Menon and Sch-wartz, 1987; Geiger et al., 1998; Carey et al., 2008). When a company collapseswithout a prior GC-modified opinion (type 2 error), potential consequences forthe auditor are loss of reputation, litigation and increased regulation (Carcelloand Palmrose, 1994; Chaney and Philipich, 2002).Descriptive evidence on the type 1 error rate finds that between 80 and 95 per

cent of companies receiving a GC-modified opinion do not subsequently fail (seefor example Altman, 1982; Mutchler and Williams, 1990; Citron and Taffler,1992; Garsombke and Choi, 1992; Nogler, 1995; Geiger et al., 1998; and Careyet al., 2008). Descriptive evidence on the type 2 error rate finds around 50 percent of bankrupt companies did not receive a GC-modified opinion, though thispercentage has varied over time (see for example Altman, 1982; Hopwood et al.,1989; Geiger and Raghunandan, 2001; Nogler, 2008; Carcello et al., 2009; Feld-mann and Read, 2010).A number of studies have explored whether changing environmental condi-

tions over time influences auditors’ going concern reporting decisions and in par-ticular, the type 2 error rate. For example, Geiger and Raghunandan (2001)examine auditors’ reactions to changes in the level of auditor liability (arguablythe primary potential cost of a type 2 error) after the introduction of the Private

Table 1

Type 1 and type 2 errors

GC-modified opinion Not GC-modified opinion

Bankrupt No error Type 2 error

Not bankrupt Type 1 error No error

GC, going-concern.



Securities Litigation Reform Act 1995 in the United States, which provided audi-tors some litigation relief. The authors find that when the risk of litigationdeclined, auditors issued fewer GC modifications to avoid the cost of makingtype 1 errors. This result is confirmed in Francis and Krishnan (2002).Following intense media and public scrutiny after the collapse of Enron in

2001, both Geiger et al. (2005) and Nogler (2008) find a lower type 2 error rate.Geiger et al. (2005) compare the type 2 error rate in 1991–1992 period with the2002–2003 period and find a lower type 2 error rate post-Enron, which they attri-bute to auditors becoming more conservative by issuing a greater proportion ofGC-modified opinions to reduce type 2 errors. Using the population of US firmsthat filed for bankruptcy for the period January 1997–December 2005, Nogler(2008) reports the going concern modification rate of 44.5 per cent for bankruptcompanies in the pre-Enron period was proportionately lower than the 61.5 percent in the immediate post-Enron period (i.e. a lower type 2 error rate).However, two studies investigating the type 2 error rate during the post-Enron

period find evidence consistent with auditors’ going concern reporting behaviourreturning to more ‘normal’ levels from 2004. Feldmann and Read (2010)reported that by 2006–2007, the proportion of type 2 errors in the United Stateshad returned to pre-Enron levels (i.e. 49 per cent). Fargher and Jiang (2008)report that while Australian auditors were issuing a higher proportion of goingconcern opinions after 2002 consistent with the trend to greater conservatism,the higher going concern modification rates in 2004 and 2005 were justified byclient risk and other variables traditionally used to explain auditor reportingdecisions.Few studies have investigated the change in the type 1 error rate over time.

Carcello et al. (2009) examined the relation between type 1 and type 2 errorsamong private firms following the introduction in Belgium in 2000 of a rule-based reporting standard. Comparing the 1995–1996 and 2001–2002 periods,Carcello et al. (2009) find a decrease in the type 2 error rate and a concomitantincrease in the type 1 error rate. This relationship was explained by auditors issu-ing a greater number of GC-modified opinions in response to an increase in thecosts of auditor acquiescence. The only other major study examining the type 1rate is Geiger and Rama (2006) who report that Big 4 auditors exhibited lowertype 1 and type 2 error rates than non-Big 4 audit reports during the 1990–2000period.This study investigates whether Australian auditors maintained GC reporting

accuracy subsequent to the turmoil following the collapse of Enron and HIH bycomparing the type 1 error rate in the 1995/1996 and 2004/2005 periods. There isempirical evidence that the type 2 error rate declined immediately post-2001(Geiger et al., 2005; Nogler, 2008) and then returned to more ‘normal’ levelsafter 2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010). While the type1 error rate was found to have increased immediately post-2001 (Carcello et al.,2009), prior research has not explored whether, like the type 2 error rate, the type1 error rate subsequently returned to more ‘normal’ or pre-2001 levels.



Descriptive evidence that Australian auditors are issued proportionally moreGC-modified opinions during the 2004/2005 period (11 per cent; Xu et al., 2011)compared with the 1995/1996 period (8 per cent; Carson et al., 2006), suggeststhat there may have been a corresponding increase in the type 1 error rate, con-sistent with the findings reported in Carcello et al. (2009). A competing argumentis that the type 1 error rate might have declined post-2002 because following thecollapse of Arthur Andersen and the ensuing media, public and legislative scru-tiny, there is evidence of greater professional scepticism (Bedard and Johnstone,2005; Sercu et al., 2006) and increased audit effort (Ghosh and Pawlewicz, 2009).However, findings that auditors’ GC reporting behaviour appeared to havereturned to ‘normal’ levels after 2003 (Fargher and Jiang, 2008; Feldmann andRead, 2010) suggest the type 1 error rate might have returned to its pre-2001levels. Weighing up the preceding arguments, we hypothesise a static type 1 errorrate comparing the 1995–1996 and 2004–2005 periods.

H1: The bankruptcy rate for companies receiving a FTGC-modified audit opinionis constant between 1995–1996 and 2004–2005.

If a company survives after receiving an FTGC-modified audit opinion, a type1 error or misclassification has occurred. A type 1 error is not necessarily indica-tive of audit failure. Behn et al. (2001) report that financially distressed compa-nies are less likely to receive an FTGC-modified audit report when their auditorsare aware that they plan to raise debt or equity to alleviate their problem. Newfinancing (or refinancing) is a mitigating factor that reduces the probability ofbankruptcy (Mutchler et al., 1997). Thus, when a company receives an FTGC-modified audit report, there is substantial doubt about the future prospects ofthe company in the absence of a new event, such as a significant injection offunds. Yet, the outcome of such a new event that was either unconfirmed or notknown to the auditor at the time of signing the GC-modified audit report maybe the reason an apparently failing company survives. In such a case, a type 1error is not necessarily indicative of an audit failure.A contribution of this study is to undertake a richer investigation into the cir-

cumstances surrounding companies that received an FTGC-modified auditreport and survived (apparent type 1 error). This study is the first to look behindthe type 1 error rate by focussing on companies that survived in the absence of alarge injection of cash (i.e. a mitigating event). Comparing the proportion offirms disclosing mitigating circumstances pre- and post-2001 is a unique proxymeasure of GC reporting accuracy.If GC reporting practices were stable during the 1995–1996 and 2004–2005

periods, then all things being equal the observed proportionate increase in GCopinions issued post-2001 would be associated with a corresponding increase inthe proportion of firms that do not disclose subsequent mitigating events after2001. Such a finding would prima facie suggest a decline in GC reportingaccuracy. In contrast, if auditors had improved audit quality post-2001, we



might observe a declining proportion of surviving companies not disclosing miti-gating circumstances subsequent to receiving an FTGC audit opinion. In view ofthese competing predictions, we hypothesise a static proportion of survivingcompanies not disclosing mitigating events consistent with auditors maintainingGC reporting accuracy post-2001.

H2: The proportion of surviving companies after receiving an FTGC-modified auditreport where there is no disclosed mitigating event is constant between 1995/1996and 2004/2005.

3. Methodology

3.1. The model

Adapted from the model used in Geiger and Rama (2006), Equation (1) is alogistic regression model, which measures the bankruptcy rate for all companiesreceiving an FTGC-modified audit opinion (i.e. firms that do not go bankruptare by definition type 1 errors).6 The model is used to test hypothesis one, whichpredicted a constant bankruptcy rate, after receiving an FTGC-modified auditopinion, between 1995/1996 and 2004/2005 (same proportion of type 1 errorscomparing pre- and post-2001), using the independent variable TIME to distin-guish the two time periods. The model takes the following form:

PROBðBKTÞ ¼ b0 þ b1LNTAþ b2PROBþ b3DFTþ b4AUD

þ b5RSKYþ b6TIMEþ ebkt0ð1Þ

where: BKT, 1 if bankrupt within 12 months of fiscal year-end, 0 otherwise;LNTA, size, measured with natural log of total assets; PROB, probability ofbankruptcy using the Hopwood model7; DFT, total liabilities/contributed equity(debt-to-equity); AUD, 1 if audited by a top tier (Big N) audit firm, and 0 other-wise; RSKY, 1 if operating in a risky industry (mining, technology), and 0

6 Geiger and Rama (2006) used the type 1 error rate to proxy audit quality, comparingthe type 1 error rate for clients of top tier verses non-top tier audit firms during the period1990–2000.

7 The Hopwood et al. (1994) model is a bankruptcy probability model that incorporatesnumerous financial indicators, being net income/total assets, current assets/sales, currentassets/current liabilities, current assets/total assets, cash/total assets, long-term debt/totalassets and natural log of sales. This model is used in Geiger et al. (2005). Other studies(i.e. Geiger and Rama, 2006) use the Zmijewski (1984) probability score as a predictor forbankruptcy. When we replaced the Hopwood model with the Zmijewski score (see Sec-tion 4), we obtained substantively the same findings.



otherwise; TIME, 1 if bankruptcy date is during the time period 2004 or 2005, 0otherwise; and ebkt’, error term.A positive relation between subsequent bankruptcy (BKT) and company size

(LNTA) is expected. While larger companies are generally less likely to receiveGC modifications, those that do are typically in great stress and thus more likelyto subsequently fail (McKeown et al., 1991; Geiger and Rama, 2006). While allcompanies receiving an FTGC-modified audit opinion are financially stressed,the evidence suggests that subsequent bankruptcy (BKT) is positively correlatedwith the level of financial stress (PROB) (Chen and Church, 1992; Carcello et al.,1995; Mutchler et al., 1997; Geiger and Rama, 2006). The present study includestotal liabilities to contributed equity (DFT) as an additional measure of financialstress. Also, an indicator variable capturing companies operating in more riskyindustries (RSKY) is a further control for the risk of bankruptcy. A positive rela-tionship is predicted between subsequent bankruptcy (BKT) and both DFT andRSKY. Geiger and Rama (2006) find that top tier (Big N) audit firms exhibithigher quality reporting by having fewer type 1 reporting errors. Companiesaudited by top tier audit firms (Big N) (AUD) are expected to be positively asso-ciated with subsequent bankruptcy (BKT). The control variables LNTA, PROBand AUD replicate those used in Geiger and Rama (2006) and the variablesDFT and RSKY are additional controls.A static type 1 error rate comparing the 1995–1996 and 2004–2005 periods is

predicted in hypothesis 1. The variable of interest, TIME, measures the impactof the pre- and post-2001 time periods on the bankruptcy rate following anFTGC-modified audit opinion (the type 1 error rate). No association betweenbankruptcy (BKT) and the variable of interest (TIME) is predicted.To test hypothesis two, which predicts that the proportion of type 1 error

observations (i.e. surviving companies) in the absence of a mitigating event willbe constant between 1995/1996 and 2004/2005, we use a test of proportions. Acomparison is made between the proportions of type 1 errors made in each timeperiod that are not explained by a mitigating event. There is no prior research lit-erature from which an established definition of a mitigating event is available.We therefore develop a unique measure to proxy mitigating events which definessuch an event as a large (comprising 10 per cent or more of the base amount)injection of debt or equity capital.

3.2. Data collected

The data set comprises the population of 165 Australian public companies thatwere issued an FTGC-modified opinion during the calendar years 1995–1996and 2004–2005. The data for 1995–1996 (57 companies) were sourced from theprivate database of Professor A Craswell and supplemented through the Con-nect4 and FinAnalysis databases. The data for 2004–2005 (108 companies) weresourced entirely through the Connect4 and FinAnalysis databases (see Table 2).Within the data set of 165 companies, bankruptcy (BKT) is where a company



enters external administration 12 months after fiscal year-end. Bankruptcy datawere drawn from a custom report ordered from the Australian Securities andInvestment Commission (ASIC).The two periods subject to analysis, 1995–1996 and 2004–2005, are both simi-

lar relatively stable periods. The period 2000–2003 is intentionally excluded fromthe study because it involved the initial post-Enron collapse adjustment and theassociated exceptional level of GC reporting activity (Xu et al., 2011), and priorresearch had previously considered type 1 GC reporting errors during the2001–2002 period (Carcello et al., 2009). The stability of the 2004–2005 period issupported by research findings that auditors GC reporting behaviour hadreturned to its pre-2001 levels after 2003 (Fargher and Jiang, 2008; Feldmannand Read, 2010). The 1995–1996 years predate the Asian economic crisis of 1997and the technology bust of 2000, events associated with heightened financial risk.The 1995–1996 period also represents a stable audit market mirroring the subse-quent 2004/2005 period with a constant number of top tier audit firms. The per-iod falls between the Ernst and Whinney merger with Arthur Young in 1989 andthe Price Waterhouse merger with Coopers and Lybrand in 1998.8 Finally, themethod comparing two, 2-year periods is consistent with the approach used inprior research (see for example Fargher and Jiang, 2008; Carcello et al., 2009).9

The data set used to test hypothesis 2 comprises all companies issued anFTGC modification that survived for 12 months after fiscal year-end (seeTable 2). Of the 57 companies issued an FTGC-modified audit report in

Table 2

Companies receiving an FTGC-modified opinion who survived (type 1 error)

Year of FTGC

Total1995/1996 2004/2005

Full dataset 57 108 165

Eliminated as subsequently bankrupt 5 8 13

Missing data 7 3 10

Final dataset 45 97 142

FTGC, first-time going concern.

8 While the auditing standards governing the GC opinion that operated during the 1995/1996 period (AUP 7) and 2004/2005 period (AUS 708) differed, they required substan-tively the same reporting. In both periods, a GC qualification signalled that an auditorbelieves there was a real risk that the company would fail in the following year. When acompany adequately disclosed that risk the auditor would issue a ‘subject to’ opinion in1995/1996 and an unqualified opinion with an ‘emphasis of matter’ in 2004/2005.

9 As noted previously, Carcello et al. (2009) examine changes to auditors GC reportingbehaviour by comparing the period 1995–1996 with 2001–2002, while Fargher and Jiang(2008) compare the 1998–1999 period with the 2003–2005 period.



1995–1996, five went bankrupt, there is missing data for a further seven, leaving45 surviving companies (type 1 errors) to be investigated. Of the 108 companiesissued an FTGC-modified audit report in 2004–2005, eight went bankrupt, thereis missing data for a further three, leaving 97 surviving companies (type 1 errors)to be investigated.Following the approach in DeFond et al. (2002), we have chosen to examine

type 1 errors using only first-time GC opinions so that the captured data repre-sent reporting decisions within each particular period. This is opposed to acontinuing GC opinion, which may not only indicate the current period decisioncriteria but also reflect circumstances at the time the GC opinion was firstissued.10

3.3. Bootstrap procedure

Although the data set used consists of the population of Australian FTGC-modified audit opinions in the years of interest, a problem arises because ofthe relatively small number of FTGC modifications in the population and thesmall number of those that subsequently go bankrupt (discussed further in theresults section below). Because of the small population data set available,drawing statistical inferences as to the difference between those companies thatsubsequently go bankrupt and those that survive is problematic.11 To over-come this problem, we apply a bootstrapping procedure which provides‘repeated’ observations which are then subject to the regression analysis to testhypothesis 1 (model 1).Bootstrapping is an approach aimed at drawing statistical inferences from a

limited population by building a sample distribution using a replacement ran-dom sampling technique (Efron, 1979). The larger data set is the result of repeat-edly drawing from the sample, replacing data and drawing again. Thereplacement method is used so that a new data set is created rather than simplyreproducing the original sample a number of times (Fox, 2002). The new andlarger sample distribution becomes the basis for statistical tests from whichconclusions can be drawn. Research finds bootstrapping is a statistically soundanalytical technique (Brownstone and Valletta, 2001; Fox, 2002; Hesterberget al., 2005). In the conclusion section of this paper, we outline the limitations ofthe bootstrap technique.

10 Because the auditor sees the removal of a GC classification once it is given as ‘a seriousand deliberate act, warranted only in exceptional circumstances,’ they are unlikely tochange it because their current mindset has shifted, but rather only when the issue behindit is resolved (Nogler, 1995).

11 After running the model with the unaltered data set, the model is non-significant, likelydue to the small sample size. All the coefficients within the model are similarly insignifi-cant, with the exception of the size control variable (LNTA, p < 0.10).



4. Results

Descriptive statistics comparing the population of Australian public companiesthat were issued an FTGC-modified audit opinion in 1995–1996 and 2004–2005are presented in Table 3. Of the 56 companies receiving an FTGC-modifiedaudit report in 1995–1996, 8.9 per cent (n = 5) went bankrupt within a year oftheir annual report balance date (the remaining 91.1 per cent survived, n = 51).Of the 108 companies receiving an FTGC-modified audit report in 2004–2005,7.4 per cent (n = 8) went bankrupt within a year of their annual report balancedate (the remaining 92.6 per cent survived, n = 100). The non-significant differ-ence in bankruptcy rate (BKT) between the two periods suggests that auditorshave, consistent with H1, maintained their reporting accuracy after 2001. Giventhe increase in the number of GC-modified opinions issued in Australia after2001 (Xu et al., 2011), the constant type 1 error rate is indicative of auditorsmaintaining reporting accuracy in the issuing of the FTGC-modified opinions byauditors.A comparison of companies across 1995–1996 and 2004–2005 time periods

shown in Table 3 reveals non-significant differences in firm size (LNTA), theprobability of bankruptcy (based on the Hopwood prediction model) (PROB)

Table 3

Descriptive statistics for FTGC-modified companies 1995–1996 and 2004–2005

Variable 1995/1996 (n = 56) 2004/2005 (n = 108)

Descriptive statistics, continuous variables: mean (SD) [median]

LNTA 15.7525

(1.7457)

[15.6300]

15.6278

(1.5271)

[15.5802]

PROB )0.0933(0.6628)

[0.0000]

)0.6107(2.7794)

[)0.0003]DFT* 1.5415

(2.8322)

[0.2736]

0.5679

(1.8062)

[0.0896]

Descriptive statistics, discrete variables

BKT 0.089 (n = 5) 0.074 (n = 8)

AUD 0.51 0.39

RSKY 0.54 0.44

*Significant difference between the two time periods at p < 0.05.

FTGC, first-time going concern; TIME, 1 if bankruptcy date during calendar year 2004 or 2005, and

0 otherwise; LNTA, company size, measured with natural log of total assets; PROB, probability of

bankruptcy using the Hopwood model; DFT, total liabilities/contributed equity (debt-to-equity);

BKT, 1 if company goes bankrupt within 12 months of fiscal year-end, 0 otherwise; AUD, 1 if

audited by a top tier (Big N) audit firm, 0 otherwise; RSKY, 1 if company operates in risky industry

(mining, technology), 0 otherwise.



and whether the companies operate in risky industries (RSKY). However, in the2004–2005 time period, companies were less highly geared (DFT, p < 0.05) andthough the variable was marginal, less likely to use a top tier audit firm (AUD,p < 0.10), than companies in the corresponding 1995–1996 time period. Thesedescriptive results suggest companies in both periods were similar, providing fur-ther support for the choice of these two relatively stable periods.A review of correlations between the variables in Equation (1) (not tabulated)

reveals the highest correlation is between company size (LNTA) and liabilities toequity (DFT) (0.383), suggesting that larger companies tend to be more highlygeared. The correlations between the independent variables did not raise anyconcerns with collinearity.Table 4 presents results for the logistic regression model for the bankruptcy

rate for all companies receiving an FTGC-modified audit opinion. The modeladequately distinguishes the bankruptcy rate (v2 = 51.79, p < 0.01). The coeffi-cients for LNTA (size), PROB (bankruptcy probability)12 and AUD (audit firm)were all significant and in the expected direction. A significant positive coefficienton the AUD variable indicates that top tier audit firms are more likely to issue

Table 4

Bootstrapped logistic regression results: FTGC 1995/1996 and 2004/2005

Prob(BKT) = b0 + b1LNTA + b2PROB + b3DFT + b4AUD + b5RSKY + b6TIME + eBKT

Variable Expected sign

Full sample

Coefficient p-Value*

Constant )9.6238 0.0001*

LNTA + 0.4489 0.0001*

PROB + 0.83 0.0108*

DFT + )0.271 0.0042*

AUD + 0.9482 0.0003*

RSKY + )0.2179 0.3813

TIME ) )0.2302 0.3834

Model chi-square = 51.7886; FTGC, first-time going concern. p-Value < 0.01.

*p < 0.05.

BKT, 1 if company goes bankrupt within 12 months of fiscal year-end, 0 otherwise; LNTA, company

size, measured with natural log of total assets; PROB, probability of bankruptcy using the Hopwood

model; DFT, total liabilities/contributed equity (debt-to-equity); AUD, 1 if audited by a top tier (Big

N) audit firm, 0 otherwise; RSKY, 1 if company operates in risky industry (mining, technology), 0

otherwise; TIME, 1 if bankruptcy date during calendar year 2004 or 2005, and 0 otherwise.

12 Results were unaffected when we replace the Hopwood bankruptcy score used to mea-sure the variable PROB with a Zmijewski financial stress score based on coefficients withthe following model: )4.803 ) 3.599(net income/total assets) + 5.406(total debt/totalassets) ) 0.100(current assets/current liabilities) (Zmijewski, 1984).



FTGC-modified opinions to companies that subsequently fail.13 This result isconsistent with US evidence of a lower type 1 reporting error rate for top tieraudit firms (Geiger and Rama, 2006) and empirical evidence that the top tier(Big N) audit firms provide a higher-quality service (see for example Francis,2004). The coefficient for DFT (debt-to-equity) was significant but negative, indi-cating that contrary to expectations, subsequently bankrupt companies had pro-portionately less debt-to-equity than surviving companies. This is unusual as itwould normally be expected that highly geared companies are at greater risk ofbankruptcy. Perhaps borrowers had reduced their exposure to these bankruptcompanies in anticipation of financial crises.The variable of interest, TIME (1995/1996 or 2004/2005), is not significant,

suggesting that auditors’ FTGC reporting accuracy is unchanged over the twoperiods. The results are consistent with hypothesis 1. Companies subject to anFTGC-modified audit opinion are no less likely to go bankrupt in the post-2001period than pre-2001 period. This result suggests that auditors maintained theirFTGC reporting accuracy during the 2004–2005 period consistent with evidencethat error rates in auditors’ reporting had returned to more ‘normal’ levels after2003 (Fargher and Jiang, 2008; Feldmann and Read, 2010).The data in Table 5 are the FTGC companies that survived (the type 1 errors).

These companies are separated into two categories: (i) companies that survivedand there was no subsequent disclosure of a mitigating event, which mightexplain why the company survived, and (ii) companies that survived that subse-quently disclosed a mitigating event which might explain why the company sur-vived. In the current study, a mitigating event is defined as a large (comprising10 per cent or more of the base amount) injection of debt or equity capital. Insuch an instance, the type 1 error is less indicative of an audit reporting error.

Table 5

Proportion of Type 1 errors with/without a mitigating event†

Audit opinion period

Total1995/1996 2004/2005

Type 1 error – no mitigating event 16 (35.6%) 43 (44.3%) 59 (41.5%)

Type 1 error – mitigating event 29 (64.4%) 54 (55.7%) 83 (58.5%)

Total 45 (100%) 97 (100%) 142 (100%)

z-score = 0.8988 (p > 0.30). †A mitigating event is defined in the present study as a large (compris-

ing 10 per cent or more of the base amount) injection of debt or equity capital.

13 In 1995/1996, there were six top tier firms (Arthur Andersen, Coopers and Lybrand,Deloitte Touche Tohmatsu, Ernst and Young, KPMG and Price Waterhouse), and in2004/2005, there were four (Deloitte Touche Tohmatsu, Ernst and Young, KPMG andPriceWaterhouseCoopers). Second tier firms are the remaining international, national andlocal firms.



Our second hypothesis predicted that the proportion of FTGC-modified sur-viving companies in the absence of a mitigating event will be constant between1995/1996 and 2004/2005. Table 5 shows that 36 per cent (16 of the 45) of sur-viving companies in 1995/1996 did not disclose a mitigating event which mayhave explained their survival. In 2005/2006, the proportion was 44 per cent (43of 97) surviving companies. Tests of proportions, where the value in each period(proportion of mitigating events) is compared to the population mean (the meancombining the two periods), indicate the difference between the two periods isnot significant (z-score = 0.8988, p > 0.30). Findings are consistent with ourprediction in H2. The finding of no variation in the rate of disclosure of mitigat-ing circumstances across the 1995–1996 and 2004–2005 periods is consistent withauditors maintaining GC reporting accuracy.14

5. Summary and conclusions

This study investigates whether Australian auditors have maintained GCreporting accuracy after 2001 using the type 1 error rate to proxy GC reportingquality. Specifically, we compare failure rates for companies that survived afterreceiving an FTGC-modified audit opinion (type 1 error rate) in 1995/1996 and2004/2005. We find that a similar proportion of companies receiving FTGCaudit opinion survived post-2001 compared to pre-2001 (i.e. a constant type 1error rate comparing the 1995/1996 and 2004/2005 periods).While the low absolute number of bankruptcies may have influenced our result

(see discussion of this limitation below), the constant type 1 error rate is nonethe-less indicative of auditors maintaining reporting accuracy post-2001. Our find-ings demonstrate that while the proportion of GC reports issued increased after2001 (Carson et al., 2006; Xu et al., 2011), this was not at the expense of adecline in auditor reporting accuracy measured using the type 1 error rate. Thisfinding is consistent with evidence of auditors increasing audit effort and profes-sional scepticism following the collapse of Enron in 2001 (Bedard and Johnstone,2005; Sercu et al., 2006) and empirical evidence that auditors’ GC reportingbehaviour returned to a ‘normal’ level after 2003 (Fargher and Jiang, 2008; Feld-mann and Read, 2010).Our findings extend the study by Carcello et al. (2009) who report an increase

in the type 1 error rate among a sample of Belgium companies in the periodimmediately post-Enron (2001–2002). Carcello et al. attributed their finding tothe trend to greater conservatism through the issuance of more GC opinionsimmediately post-2001 (representing a technical reduction in GC reporting accu-racy). The contrasting results in the present study might be explained by the

14 It is noteworthy that this result also serves as a control to ensure that a change in theunderlying rate of disclosure of mitigating events did not provide an alternative explana-tion for the constant bankruptcy rate between 1995–1996 and 2004–2005 periods (H1).



choice of time period. Carcello et al. (2009) investigated the immediately post-2001 time period when the audit market was in its greatest turmoil, while thepresent study uses the 2004–2005 period, when the audit market had stabilised.For companies that received an FTGC audit opinion and survived (type 1

errors), this study is the first to distinguish between those companies that dis-closed mitigating events in their subsequent financial statements, which providessome explanation for their survival, from companies that did not disclose miti-gating events. Mitigating events are defined in the present study as a large (com-prising 10 per cent or more of the base amount) injection of debt or equitycapital. We find that 36 per cent (16 of the 45) of surviving companies in 1995/1996 did not disclose a mitigating event which may have explained their survival,whereas in 2005/2006 the proportion was 44 per cent (43 of 97). However, testsof proportions indicate that the difference between the two periods is not signifi-cant.Given the increase in the proportion of GC opinions issued post-2001 (Carson

et al., 2006; Xu et al., 2011), a corresponding reduction in the proportion of sur-viving companies disclosing mitigating circumstances would have suggested thatauditors were simply being more conservative in issuing more GC opinions. Ourresults provide evidence of auditors maintaining reporting accuracy post-2001.The stable rate of disclosure of mitigating events over the pre- and post-2001periods provides further support for the argument that auditors have maintainedGC reporting accuracy.A limitation of this study is the small sample size owing to the small number

of companies issued an FTGC opinion in Australia. In particular, the non-sig-nificant differences in both bankruptcy rates (H1) and the rate of non-disclosureof mitigating events (H2) might have changed had the actual population sizebeen larger. The strength of the method used in this paper is that the resultsreflect the population of companies issued an FTGC audit opinion and aretherefore indicative of auditors’ reporting habits. Future research could extendthe sample size by conducting the analysis over a longer time period or replicat-ing the analysis in a jurisdiction with a larger population of FTGC audit opin-ions (i.e. USA).To overcome concerns regarding the small population of FTGC audit opin-

ions, we used a bootstrapping technique. A limitation of this method is that indi-vidual data points appear in the data set more than once to increase the overallsize of the data set. Notwithstanding this potential limitation, a number ofstudies confirm the validity of statistical inference from bootstrapping (see forexample, Brownstone and Valletta, 2001; Fox, 2002; Hesterberg et al., 2005).In motivating our second hypothesis, we note that mitigating events may

explain why companies that receive a GC-modified opinion survive. In the cur-rent study, we identify only one mitigating event, a large (comprising 10 per centor more of the base amount) injection of debt or equity capital. We acknowledgethat this is a limitation as there are potentially other events that could explainwhy companies survive after receiving a GC-modified audit report.



Finally, although this study focuses on identifying change in auditors’ decisionmaking process, it is limited by the fact that the method used cannot directlymeasure the changes that have occurred or have been enacted in audit processes.Type 1 error rates, the tool of the present study, are measurable outcomes of thisprocess, indicating changed reporting habits but not specifically what changeshave occurred in the audit process. Future studies may attempt to collect moredirect evidence from audit firms (for example internal policy documents) to iden-tify whether in fact there is a genuine change in the criteria used for judging theappropriateness of the GC assumption after 2001.

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